Soldiers march past a sign of the Taiwan flag on Dongyin island
Soldiers march past a sign of the Taiwan flag on Dongyin island of Matsu archipelago in Taiwan August 15, 2022. Reuters

The threat of China invading Taiwan, long considered a highly improbable event, has moved to the centre of global money managers' risk radars and is factoring in their investment decisions, analysts say.

Fund managers say they are fielding more queries from clients about the odds of an invasion of Taiwan by China. Although none of them has made specific trades related to that risk, their overall exposure to China has reduced for other geopolitical reasons, and Taiwan figures heavily in asset allocation plans.

Taiwan has long been a flashpoint in U.S.-China relations, which have in recent weeks been put under further strain after a suspected Chinese spy balloon was shot down and the United States expanded a programme in which its troops help train Taiwanese forces.

Chinese President Xi Jinping's statements at October's Communist Party Congress, when he won a precedent-breaking third leadership term, had already raised alert levels after he repeated comments that China would pursue control of the self-governed island and never renounce the right to use force.

Taiwan's president, Tsai Ing-wen, has repeatedly pledged to uphold peace and avoid provocation. She has offered talks with China, but has also said Taiwan will defend itself if attacked.

Russia's invasion of Ukraine early last year has also made investors more wary of war risk, analysts said.

"In Europe, since some investors have ... made quite a few losses in Russia, from a risk management point of view, they can't afford it if something goes wrong in the Taiwan Strait," said a senior analyst at a U.S. fund house, who declined to be named because of the sensitivity of the topic.

He says many clients have asked how to think about it, and it is a risk his firm has been monitoring.

"It hasn't come to the point where you really need to take any decisive action, such as cut exposure here or there," he said.

Goldman Sachs' Cross-Strait Risk Index, which gauges the intensity of geopolitical risk between Taiwan and mainland China, hit a record high last August after then-U.S. House of Representatives Speaker Nancy Pelosi's trip to Taiwan. It has since moderated.

"We are at similar levels compared to a year ago, following a spike after the Russian invasion of Ukraine. However, the level is relatively higher than the average in 2021," said Alvin So, a strategist at Goldman Sachs.

Spreads on Taiwanese 5-year credit default swaps have held at 176 basis points since last March, nearly 30 bp higher from where they were at the start of last year.

"The last 12 to 18 months has taught us that we can't take anything for granted when it comes to geopolitics," said Will Malcolm, a portfolio manager at Aviva Investors.

China's foreign ministry did not immediately respond to a request for comment. The country's top diplomat, Wang Yi, has said Taiwan "independence forces" are incompatible with peace.

"If we want to maintain peace across the Taiwan Strait, we must resolutely oppose Taiwan independence, and we must resolutely maintain the one-China policy," he said at the Munich Security Conference on Feb. 18.

LOW ODDS, HIGH SHOCK

"Realistically, if there is ultimately a conflict between China and Taiwan, I think the ramifications are going to be far more severe than necessarily worrying about which company you should be holding in the markets," Malcolm said. "Even if you parked all your assets in the U.S., you'd still be very significantly exposed given the profound direct and indirect economic linkages to China and Taiwan."

Some funds have reduced their exposure in China and are instead seeking names that provide insulation from geopolitical tensions.

Jordan Stuart, client portfolio manager at Federated Hermes, says he cut China exposure last year while holding onto some small stocks that can "fly under the radar".

"If things stay stagnant, or escalate, what we're going to pivot to is the more industrial and capex cycle on the reshoring trade ... instead of owning global industrial companies that have exposure to China or elsewhere," he said. "I'm going to go smaller, more domestic names, that would play into that capex cycle."

A Chinese invasion of Taiwan would also cause significant supply chain disruptions and turmoil in global markets such as the ones brought about by the COVID-19 pandemic and Russia's invasion of Ukraine.

The Taiwan Strait is a major route for ships transporting goods from East Asia to the United States and Europe. Taiwan has also emerged as a key battlefront in the chip industry supply chain.

"China wouldn't have to invade Taiwan or actually get hot to just cause a stir in that part of the market," Stuart said. "That bottleneck can cause absolute disruption in the global economy. I think that's underestimated."